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Portfolio > Alternative Investments > Hedge Funds

The 40% Solution to Hedge Fund Investing

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Index June 2003 QTD YTD Description
S&P 500 1.13% 14.88% 10.76% Large-cap stocks
DJIA 1.53% 12.44% 7.72% Large-cap stocks
Nasdaq Composite 1.68% 21.00% 21.51% Large-cap tech stocks
Russell 1000 Growth 1.54% 14.49% 13.27% Large-cap growth stocks
Russell 1000 Value 1.48% 17.54% 11.82% Large-cap value stocks
Russell 2000 Growth 2.06% 24.31% 19.49% Small-cap growth stocks
Russell 2000 Value 1.74% 22.78% 16.54% Small-cap value stocks
MSCI EAFE 2.56% 19.25% 9.68% Europe, Australasia & Far East Index
Lehman Aggregate -0.20% 2.50% 3.93% U.S. Government Bonds
Lehman High Yield 2.88% 10.10% 18.49% High-yield corporate bonds
Carr CTA Index -0.89% 5.36% 10.28% Managed futures
Through June 30, 2003.

Indexed investing is a strategy that is designed to match the return of a given asset class. As a practical application of the efficient market hypothesis, which states that generating market-beating returns is all but impossible, low cost index products have managed to beat the majority of their actively managed peers. Can something that works so well with equity and fixed income investments also apply to hedge funds?

A fair number of enterprising firms, including Standard and Poor’s and CSFB/Tremont, believe that it can. But this process may not be as straightforward as one might think. In fact, it is the significant differences between alternative and traditional investing–and not the similarities–that will determine whether indexing is useful among hedge funds and managed futures

The most often-used proxy for the stock market is the Standard and Poor’s 500 index, which consists of the most liquid and largest publicly traded U.S. companies. Because this index is dollar-weighted, an indexer can come close to mimicking its returns by purchasing the fifty largest stocks, which collectively account for a large percentage of the float of the index. This allows institutions with relatively modest dollar amounts to closely follow the index, since direct replication is difficult for all but the largest investors.

Hedge fund indexers have borrowed from this concept, with many of them stating that to replicate the returns of the more popular alternative benchmarks, an allocation to only the largest managers is necessary. But in the real world, this approach means using only the largest available funds, since the best and brightest are closed to all but the most connected investors.

And then there is the heterogeneity problem. Performance of funds within the same sector is alarmingly different, especially within such a disparate strategy as equity market neutral, where the difference between the haves and the have-nots can vary by 10% to 20% in a given year.

At the fund of funds investor level, it all comes down to cost. Are indexed hedge fund products, which usually charge about 2% per year, a better deal than actively managed funds of funds and their 1% management/10% incentive fee levy? According to a recent study by Jimmy Liew of Carlyle Asset Management, about 30% of all hedge funds generate significant alpha. If an active FoF manager can maintain a hit rate of 40% (i.e., 40% of his portfolio is composed of alpha-producing managers), the additional fees are more than offset by enhanced performance. Whether this statistic puts the onus on the active or passive side remains to be seen.

The hedge fund indexing game is so new that picking winners and losers at this point is fruitless. In my experience, the best returns in hedge funds come to those that have access to proven talent. For this reason, I’d be inclined to choose an actively managed fund with a good stable of managers and a respectable tenure over a low-priced alternative.


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